'Dumb' Investors Turn Out To Be Shrewd

Academics claim managed fund choices earn results no better than a total index. A new study follows the money and finds more positive results.

Rekenthaler says that in order to get a realistic picture of how the typical investor fared, you should calculate the asset-weighted returns -- the average return of each invested dollar. That way you give more weight to large funds. Calculating the asset-weighted returns, Rekenthaler found that typical investors had been getting decent results.

On average the asset-weighted returns were higher than the returns recorded by weighting all funds equally. This suggests that investors are systemically selecting superior funds. "Investors have done better than if they had picked funds by throwing darts," says Rekenthaler.

According to the Morningstar data, investors have been gravitating to big funds with low expenses and strong returns. That has been a smart move. Because of economies of scale, big funds tend to have lower fees. The low expense ratios help the funds produce competitive returns. "The big funds are reasonably well run and cheaper," says Rekenthaler. "People are not doing major damage to themselves through fund selection."

Investors have proved particularly successful in picking small-cap funds. On an asset-weighted basis, small growth funds returned 3.98% annually during the 10 years ending in 2010. That topped the benchmark by 0.20%.

The asset-weighted results outdid the benchmarks in a variety of fund categories, including foreign large value, emerging markets and health funds. The active funds trailed in large growth and large value. Altogether the asset-weighted results outdid the benchmarks in eight of the 17 categories studied by Morningstar. In most categories where the active funds trailed, they lagged by small amounts. In general, investors in the active funds achieved results that were competitive with index funds.

In light of the Morningstar results, should you focus on big active funds? Not necessarily. The study makes clear that investors can get good returns with either active or passive funds of all sizes. But no matter which kind of fund you pick, it is important to stick with low-cost choices. Funds with low expense ratios enjoy an advantage that is hard to overcome.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.